Fundamentals of corporate finance 9e by ross jordan case solutions

To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Case Solutions Fundamentals of Corporate Finance Ross, Westerfield, and Jordan 9th edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER THE McGEE CAKE COMPANY The advantages to a LLC are: 1) Reduction of personal liability A sole proprietor has unlimited liability, which can include the potential loss of all personal assets 2) Taxes Forming an LLC may mean that more expenses can be considered business expenses and be deducted from the company’s income 3) Improved credibility The business may have increased credibility in the business world compared to a sole proprietorship 4) Ability to attract investment Corporations, even LLCs, can raise capital through the sale of equity 5) Continuous life Sole proprietorships have a limited life, while corporations have a potentially perpetual life 6) Transfer of ownership It is easier to transfer ownership in a corporation through the sale of stock The biggest disadvantage is the potential cost, although the cost of forming a LLC can be relatively small There are also other potential costs, including more expansive record-keeping Forming a corporation has the same advantages as forming a LLC, but the costs are likely to be higher As a small company, changing to a LLC is probably the most advantageous decision at the current time If the company grows, and Doc and Lyn are willing to sell more equity ownership, the company can reorganize as a corporation at a later date Additionally, forming a LLC is likely to be less expensive than forming a corporation To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER CASH FLOWS AND FINANCIAL STATEMENTS AT SUNSET BOARDS Below are the financial statements that you are asked to prepare The income statement for each year will look like this: Income statement 2008 2009 $247,259 126,038 24,787 35,581 $60,853 7,735 $53,118 10,624 $42,494 $301,392 159,143 32,352 40,217 $69,680 8,866 $60,814 12,163 $48,651 $21,247 21,247 $24,326 24,326 Sales Cost of goods sold Selling & administrative Depreciation EBIT Interest EBT Taxes Net income Dividends Addition to retained earnings The balance sheet for each year will be: Balance sheet as of Dec 31, 2008 Cash Accounts receivable Inventory Current assets Net fixed assets Total assets $18,187 12,887 27,119 $58,193 $156,975 $215,168 Accounts payable Notes payable Current liabilities Long-term debt Owners' equity Total liab & equity $32,143 14,651 $46,794 $79,235 89,139 $215,168 In the first year, equity is not given Therefore, we must calculate equity as a plug variable Since total liabilities & equity is equal to total assets, equity can be calculated as: Equity = $215,168 – 46,794 – 79,235 Equity = $89,139 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com C-2 CASE SOLUTIONS Balance sheet as of Dec 31, 2009 Cash Accounts receivable Inventory Current assets Net fixed assets Total assets $27,478 16,717 37,216 $81,411 Accounts payable Notes payable Current liabilities Long-term debt Owners' equity Total liab & equity $191,250 $272,661 $36,404 15,997 $52,401 $91,195 129,065 $272,661 The owner’s equity for 2009 is the beginning of year owner’s equity, plus the addition to retained earnings, plus the new equity, so: Equity = $89,139 + 24,326 + 15,600 Equity = $129,065 Using the OCF equation: OCF = EBIT + Depreciation – Taxes The OCF for each year is: OCF2008 = $60,853 + 35,581 – 10,624 OCF2008 = $85,180 OCF2009 = $69,680 + 40,217 – 12,163 OCF2009 = $97,734 To calculate the cash flow from assets, we need to find the capital spending and change in net working capital The capital spending for the year was: Capital spending Ending net fixed assets – Beginning net fixed assets + Depreciation Net capital spending $191,250 156,975 40,217 $74,492 And the change in net working capital was: Change in net working capital Ending NWC – Beginning NWC Change in NWC $29,010 11,399 $17,611 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER C-3 So, the cash flow from assets was: Cash flow from assets Operating cash flow – Net capital spending – Change in NWC Cash flow from assets $97,734 74,492 17,611 $ 5,631 The cash flow to creditors was: Cash flow to creditors Interest paid – Net new borrowing Cash flow to creditors $8,866 11,960 –$3,094 The cash flow to stockholders was: Cash flow to stockholders Dividends paid – Net new equity raised Cash flow to stockholders $24,326 15,600 $8,726 Answers to questions The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations The firm invested $17,611 in new net working capital and $74,492 in new fixed assets The firm gave $5,631 to its stakeholders It raised $3,094 from bondholders, and paid $8,726 to stockholders The expansion plans may be a little risky The company does have a positive cash flow, but a large portion of the operating cash flow is already going to capital spending The company has had to raise capital from creditors and stockholders for its current operations So, the expansion plans may be too aggressive at this time On the other hand, companies need capital to grow Before investing or loaning the company money, you would want to know where the current capital spending is going, and why the company is spending so much in this area already To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER RATIOS ANALYSIS AT S&S AIR The calculations for the ratios listed are: Current ratio = $2,186,520 / $2,919,000 Current ratio = 0.75 times Quick ratio = ($2,186,250 – 1,037,120) / $2,919,000 Quick ratio = 0.39 times Cash ratio = $441,000 / $2,919,000 Cash ratio = 0.15 times Total asset turnover = $30,499,420 / $18,308,920 Total asset turnover = 1.67 times Inventory turnover = $22,224,580 / $1,037,120 Inventory turnover = 21.43 times Receivables turnover = $30,499,420 / $708,400 Receivables turnover = 43.05 times Total debt ratio = ($18,308,920 – 10,069,920) / $18,308,920 Total debt ratio = 0.45 times Debt-equity ratio = ($2,919,000 + 5,320,000) / $10,069,920 Debt-equity ratio = 0.82 times Equity multiplier = $18,308,920 / $10,069,920 Equity multiplier = 1.82 times Times interest earned = $3,040,660 / $478,240 Times interest earned = 6.36 times Cash coverage = ($3,040,660 + 1,366,680) / $478,420 Cash coverage = 9.22 times Profit margin = $1,537,452 / $30,499,420 Profit margin = 5.04% Return on assets = $1,537,452 / $18,308,920 Return on assets = 8.40% Return on equity = $1,537,452 / $10,069,920 Return on equity = 15.27% To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER C-5 Boeing is probably not a good aspirant company Even though both companies manufacture airplanes, S&S Air manufactures small airplanes, while Boeing manufactures large, commercial aircraft These are two different markets Additionally, Boeing is heavily involved in the defense industry, as well as Boeing Capital, which finances airplanes Bombardier is a Canadian company that builds business jets, short-range airliners and fire-fighting amphibious aircraft and also provides defense-related services It is the third largest commercial aircraft manufacturer in the world Embraer is a Brazilian manufacturer than manufactures commercial, military, and corporate airplanes Additionally, the Brazilian government is a part owner of the company Bombardier and Embraer are probably not good aspirant companies because of the diverse range of products and manufacture of larger aircraft Cirrus is the world's second largest manufacturer of single-engine, piston-powered aircraft Its SR22 is the world's best selling plane in its class The company is noted for its innovative small aircraft and is a good aspirant company Cessna is a well known manufacturer of small airplanes The company produces business jets, freight- and passenger-hauling utility Caravans, personal and small-business single engine pistons It may be a good aspirant company, however, its products could be considered too broad and diversified since S&S Air produces only small personal airplanes S&S is below the median industry ratios for the current and cash ratios This implies the company has less liquidity than the industry in general However, both ratios are above the lower quartile, so there are companies in the industry with lower liquidity ratios than S&S Air The company may have more predictable cash flows, or more access to short-term borrowing If you created an Inventory to Current liabilities ratio, S&S Air would have a ratio that is lower than the industry median The current ratio is below the industry median, while the quick ratio is above the industry median This implies that S&S Air has less inventory to current liabilities than the industry median S&S Air has less inventory than the industry median, but more accounts receivable than the industry since the cash ratio is lower than the industry median The turnover ratios are all higher than the industry median; in fact, all three turnover ratios are above the upper quartile This may mean that S&S Air is more efficient than the industry The financial leverage ratios are all below the industry median, but above the lower quartile S&S Air generally has less debt than comparable companies, but still within the normal range The profit margin, ROA, and ROE are all slightly below the industry median, however, not dramatically lower The company may want to examine its costs structure to determine if costs can be reduced, or price can be increased Overall, S&S Air’s performance seems good, although the liquidity ratios indicate that a closer look may be needed in this area To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com C-6 CASE SOLUTIONS Below is a list of possible reasons it may be good or bad that each ratio is higher or lower than the industry Note that the list is not exhaustive, but merely one possible explanation for each ratio Ratio Current ratio Quick ratio Cash ratio Total asset turnover Inventory turnover Receivables turnover Good Better at managing current accounts Better at managing current accounts Better at managing current accounts Better at utilizing assets Better at inventory management, possibly due to better procedures Better at collecting receivables Total debt ratio Less debt than industry median means the company is less likely to experience credit problems Debt-equity ratio Less debt than industry median means the company is less likely to experience credit problems Equity multiplier Less debt than industry median means the company is less likely to experience credit problems TIE Higher quality materials could be increasing costs Cash coverage Less debt than industry median means the company is less likely to experience credit problems Profit margin The PM is slightly below the industry median It could be a result of higher quality materials or better manufacturing Company may have newer assets than the industry Lower profit margin may be a result of higher quality ROA ROE Bad May be having liquidity problems May be having liquidity problems May be having liquidity problems Assets may be older and depreciated, requiring extensive investment soon Could be experiencing inventory shortages May have credit terms that are too strict Decreasing receivables turnover may increase sales Increasing the amount of debt can increase shareholder returns Especially notice that it will increase ROE Increasing the amount of debt can increase shareholder returns Especially notice that it will increase ROE Increasing the amount of debt can increase shareholder returns Especially notice that it will increase ROE The company may have more difficulty meeting interest payments in a downturn Increasing the amount of debt can increase shareholder returns Especially notice that it will increase ROE Company may be having trouble controlling costs Company may have newer assets than the industry Profit margin and EM are lower than industry, which results in the lower ROE To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER PLANNING FOR GROWTH AT S&S AIR To calculate the internal growth rate, we first need to find the ROA and the retention ratio, so: ROA = NI / TA ROA = $1,537,452 / $18,309,920 ROA = 0840 or 8.40% b = Addition to RE / NI b = $977,452 / $1,537,452 b = 0.64 Now we can use the internal growth rate equation to get: Internal growth rate = (ROA × b) / [1 – (ROA × b)] Internal growth rate = [0.0840(.64)] / [1 – 0.0840(.64)] Internal growth rate = 0564 or 5.64% To find the sustainable growth rate, we need the ROE, which is: ROE = NI / TE ROE = $1,537,452 / $10,069,920 ROE = 1527 or 15.27% Using the retention ratio we previously calculated, the sustainable growth rate is: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)] Sustainable growth rate = [0.1527(.64)] / [1 – 0.1527(.64)] Sustainable growth rate = 1075 or 10.75% The internal growth rate is the growth rate the company can achieve with no outside financing of any sort The sustainable growth rate is the growth rate the company can achieve by raising outside debt based on its retained earnings and current capital structure To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com C-8 CASE SOLUTIONS Pro forma financial statements for next year at a 12 percent growth rate are: Income statement Sales COGS Other expenses Depreciation EBIT Interest Taxable income Taxes (40%) Net income $ 34,159,350 24,891,530 4,331,600 1,366,680 $ 3,569,541 478,240 $ 3,091,301 1,236,520 $ 1,854,780 Dividends Add to RE $ 675,583 1,179,197 Balance sheet Assets Current Assets Cash Accounts rec Inventory Total CA $ 493,920 793,408 1,161,574 $ 2,448,902 Liabilities & Equity Current Liabilities Accounts Payable $ Notes Payable Total CL $ 995,680 2,030,000 3,025,680 Long-term debt 5,320,000 Fixed assets Net PP&E $ 18,057,088 Shareholder Equity Common stock Retained earnings Total Equity Total Assets $ 20,505,990 Total L&E $ $ 350,000 10,899,117 $ 11,249,117 $ 19,594,787 So, the EFN is: EFN = Total assets – Total liabilities and equity EFN = $20,505,990 – 19,594,797 EFN = $911,193 The company can grow at this rate by changing the way it operates For example, if profit margin increases, say by reducing costs, the ROE increases, it will increase the sustainable growth rate In general, as long as the company increases the profit margin, total asset turnover, or equity multiplier, the higher growth rate is possible Note however, that changing any one of these will have the effect of changing the pro forma financial statements To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 21 S&S AIR GOES INTERNATIONAL The biggest advantage is the increased sales, while the biggest risk is exchange rate risk If the dollar strengthens, the profit will decline Conversely, if the dollar weakens, the profit will increase The company will pay the sales commission out of gross sales, so the after-commission sales in euros is: After-commission sales = €5,000,000(1 – 05) After-commission sales = €4,750,000 At the current exchange rate of $1.45/€, the EBT in euros will be converted to dollars in the amount of: Dollar EBT = €750,000($1.45/€) Dollar EBT = $6,887,500 S&S Air has production costs equal to 80 percent of dollar sales at this exchange rate: The total sales in dollars are: Total sales = €5,000,000($1.45/€) Total sales = $7,250,000 And the production costs are: Production costs = $7,250,000(0.80) Production costs = $5,800,000 So, the profit at the current exchange rate is: Profit = $6,887,500 – 5,800,000 Profit = $1,087,500 If the exchange rate changes to $1.30/€, the euros will convert to: Dollar sales = €4,750,000($1.30/€) Dollar sales = $6,175,000 Since the production costs are fixed, the profit at this exchange rate will be: Profit = $6,175,000 – 5,800,000 Profit = $375,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 21 C-60 The breakeven exchange rate is the exchange rate that will allow the after-commission costs in euros to convert to a dollar amount that covers the production costs, so: Breakeven exchange rate = $5,800,000/€4,750,000 Breakeven exchange rate = $1.221/€ The company could use options, futures, or forwards The downside to all three hedging vehicles is the cost Over time, the company will gain on some contracts and lose on others At the current exchange rate, the company will make a profit unless the exchange rate moves dramatically So, it is likely that hedging is not required at this point Taking this into account, the company should probably pursue international sales further To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 22 YOUR 401k ACCOUNT AT EAST COAST YACHTS Before the fact, you would expect that mutual funds managers would be able to outperform the market This is due, in part, to the Darwinian nature of the business Good performing fund managers are richly rewarded, and poor performing fund managers are fired, often very quickly In reality, we should expect that less than 50 percent of all equity mutual funds would outperform the market This does not depend on the level of market efficiency Consider the following question: What percentage of investors will outperform the market in a given year? Answer: Fifty percent While there could be one really poor investor who takes all of the losses in a given year, in general, to get the market average we would expect one-half of investors would outperform the market, and one-half would underperform the market After all, the market average return has to be the average return of all investors’ average return This is definitely true if we consider the weighted average return, that is, the average return of investors weighted by the dollar amount of the investment We would expect more than 50 percent of mutual funds would underperform the market because of the expenses charged by the mutual funds Consider the large-cap stock fund, with and expense ratio of 1.50 percent The fund must exceed the market return by 1.50 percent before fees in order to achieve a return after fees equal to the market return Whether the market is efficient or inefficient is irrelevant unless mutual funds managers are the best investors in the market, and all other investors, including private money managers, pension fund managers, individuals, etc are the bad investors in the market We should also consider that mutual funds managers may be able to outperform the market before expenses Whether they can outperform the market on an after-expense basis becomes a question of whether mutual fund managers can extract economic rents from the stock market The evidence tends to support the idea that they cannot In general, research has found that mutual fund managers underperform the market after expenses by the average expense ratio This means that mutual funds as a whole tend to have the market average return before expenses, so they not appear to be able to outperform the market The results in the graph tend to support the idea of market efficiency Consider the case of the Fidelity Magellan Fund, one of the largest actively managed equity mutual funds at the time this was written, with assets of about $55 billion So the question is this: What would Fidelity pay for one year to increase the return of the Magellan Fund by 0.01 percent? If we multiply the fund assets by 0.01 percent, we get: $55,000,000,000(.0001) = $5,500,000 So, if Fidelity can increase the return of this one fund by only 0.01 percent per year, it should be willing to pay up to $5.5 million for that year Given the amount mutual fund companies would be willing to spend for research, and the Darwinian nature of the industry, we would expect that mutual fund managers should be able to outperform the market While there have been notable exceptions, such as Peter Lynch’s tenure at Magellan, as a whole, mutual fund managers not seem to be able to outperform the market As a result, if the “best” and definitely best-financed investors cannot outperform the market, the results support the concept of market efficiency To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 22 C-62 Given that the evidence presented tends to support market efficiency, you should invest in the S&P 500 index fund However, this is not the entire answer By investing the entire equity portion of your account in the S&P 500 index, your portfolio is not diversified since the S&P 500 index includes only large-cap stocks Therefore, part of your equity investment should probably be in the small cap fund for diversification purposes Note that a small cap index fund may be the best option, but there is no small cap index fund available in the 401k account To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 23 CHATMAN MORTGAGE, INC Mike’s mortgage payments form a 25-year annuity with monthly payments, discounted at the longterm interest rate of percent We can solve for the payment amount so that the present value of the annuity equals $500,000, the amount of principal that he plans to borrow The monthly mortgage payment will be: $500,000 = C(PVIFA7%/12,300) C = $3,533.90 The most significant risk that she faces is interest rate risk If the current market rate of interest rises between today and the date the mortgage is sold, the fair value of the mortgage will decrease, and the Ian will only be willing to purchase the mortgage for a price less than $500,000 If this is the case, she will not be able to loan Mike the full $500,000 promised Treasury bond prices have an inverse relationship with interest rates As interest rates rise, Treasury bonds become less valuable; as interest rates fall, Treasury bonds become more valuable Since Joi will be hurt when interest rates rise, she is also hurt when Treasury bonds decrease in value In order to protect herself from decreases in the price of Treasury bonds, she should take a short position in Treasury bond futures to hedge this interest rate risk Since three-month Treasury bond futures contracts are available and each contract is for $100,000 of Treasury bonds, she would take a short position in five 3-month Treasury bond futures contracts in order to hedge her $500,000 exposure to changes in the market interest rate over the next three months a If the market interest rate is percent on the date that Joi meets with the Ian, the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3,533.90 for 25 years, discounted at percent, or: Mortgage value = $3,533.90(PVIFA8%/12,300) Mortgage value = $457,867.55 b An increase in the interest rate will cause the value of the T-bond futures contracts to decrease The long position will lose and the short position will gain Since Joi is short in the futures, the futures gain will offset the loss in value of the mortgage a If the market interest rate is percent on the date that Joi meets with the Ian, the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3,533.90 for 25 years, discounted at percent, or: Mortgage value = $3,533.90(PVIFA6%/12,300) Mortgage value = $548,484.91 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 23 C-64 b An increase in the interest rate will cause the value of the Treasury bond futures contracts to increase The long position will gain and the short position will lose Since Joi is short in the futures, the futures lose will be offset by the gain in value of the mortgage The biggest risk is that the hedge is not a perfect hedge If interest rates change, the fact that Treasury bond interest is semiannual, while the mortgage payments are monthly, may affect the relative value of the two Additionally, while a change in one of the interest rates will likely coincide with a change in the other interest rate, the change does not have to be the same For example, the Treasury rate could increase 20 basis points, and the mortgage rates could increase by 40 basis points The fact that this is not a perfect hedge simply means that the gain/loss from the futures contracts may not exactly offset the loss/gain in the mortgage We would expect, especially given the short-term nature of the hedge, that the loss in one instrument would be similar to the gain in the other instrument To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 24 S&S AIR’S CONVERTIBLE BOND We can use the PE ratio to calculate the current stock price Doing so, we get: P/E = Price/EPS 12.50 = Price/$1.60 Price = $20.00 This means the conversion premium of the bond is: Conversion premium = ($25 – 20) / $20 = 0.25 or 25% Chris is suggesting a conversion price of $25 because it means the stock price will have to increase before the bondholders can benefit from the conversion, in this case 25 percent Even though the company is not publicly traded, the conversion price is important First, the company may go public in the future The case does discuss whether the company has plans to go public, and if so, how soon it might go public If the company does goes public, the bondholders will have an active market for the stock if they convert Second, even if the company does not go public, the bondholders could potentially have an equity interest in the company This equity interest can be sold to the original owners, or someone else The potential problem with private equity is that the market is not as liquid as the market for a public company This illiquidity lowers the value of the stock The conversion value of the bond is given as $800 The intrinsic value of the bond is: Intrinsic value = $30(PVIFA5%,40) + $1000(PVIF5%,40) Intrinsic value = $656.82 So, the floor value of the bond is $800 This means that if the company offered bonds with the same coupon rate and no conversion feature, they would be able to sell them for $656.82 However, with the conversion feature the price will be $800 In essence, the company is receiving $143.18 for the conversion feature The conversion ratio the bond is: Conversion ratio = $800/$25 = 32.00 So, each bond can be converted to 32 shares of stock Todd’s argument is wrong because it ignores the fact that if the company does well, bondholders will be allowed to participate in the company’s success If the stock price rises to $25, bondholders are effectively allowed to purchase stock at the conversion price of $25 Mark’s argument is incorrect because the company is issuing debt with a lower coupon rate than they would have been able to otherwise If the company does poorly, it will receive the benefit of a lower coupon rate To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 23 C-66 Reconciling the two arguments requires that we remember our central goal: to increase the wealth of the existing shareholders Thus, with 20-20 hindsight, we see that issuing convertible bonds will turn out to be worse than issuing straight bonds and better than issuing common stock if the company prospers The reason is that the prosperity has to be shared with bondholders after they convert In contrast, if a company does poorly, issuing convertible bonds will turn out to be better than issuing straight bonds and worse than issuing common stock The reason is that the firm will have benefited from the lower coupon payments on the convertible bonds Both of the arguments have a grain of truth; we just need to combine them Ultimately, which option is better for the company will only be known in the future and will depend on the performance of the company The table below illustrates this point Convertible bonds issued instead of straight bonds Convertible bonds issued instead of common stock If the company does poorly Low stock price and no conversion Cheap financing because coupon rate is lower (good outcome) If the company prospers High stock price and conversion Expensive financing because bonds are converted, which dilutes existing equity (bad outcome) Expensive financing because firm could have issued common stock at high prices (bad outcome) Cheap financing because firm issues stock at high prices when bonds are converted (good outcome) The call provision allows the company to redeem the bonds at the company’s discretion If the company’s stock appears to be poised to rise, the company can call the outstanding bonds It could be possible that the bondholders would benefit from converting the bonds at that point, but it would eliminate the potential future gains to the bondholders To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 25 EXOTIC CUISINE EMPLOYEE STOCK OPTIONS We can use the Black-Scholes equation to value the employee stock options We need to use the risk-free rate that is the same as the maturity as the options So, assuming expiration in three years, the value of the stock options per share of stock is: d1 = [ln($24.38/$50) + (.038 + 602/2) d2 = –.0618 – (.60 3] / (.60 ) = –.0618 ) = –1.1011 N(d1) = 4753 N(d2) = 1354 Putting these values into the Black-Scholes model, we find the option value is: C = $24.38(.4753) – ($50e–.038(3))(.1354) = $5.55 Assuming expiration in ten years, the value of the stock options per share of stock is: d1 = [ln($24.38/$50) + (.044 + 602/2) d2 = 8020 – (.60 10] / (.60 10 ) = 8020 10 ) = –1.0953 N(d1) = 7887 N(d2) = 1367 Putting these values into the Black0Scholes model, we find the option value is: C = $24.38(.7887) – ($50e–.044(10))(.1367) = $14.83 Whether you should exercise the options in three years depends on several factors A primary factor is how long you plan to stay with the company If you are planning to leave next week, you should exercise the options A second factor is how the option exercise will affect your taxes The fact that the employee stock options are not traded decreases the value of the options A basic way to understand this is to realize that an option always has value since, ignoring the premium, it can never lose money The right to sell an option also has to have value If the right to sell is removed, it decreases the price of the option To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 25 C-68 The rationale for employee stock options is to reduce agency costs by better aligning employee and shareholder interests Vesting requires employees to work at a company for a specified time, which means the employee actions are actually part of the company performance Vesting is also a “golden handcuff.” The employee is less likely to leave the company if in-the-money employee stock options will vest soon They must often be exercised shortly after an employee leaves the company so that they may no longer participate in any potential stock price increase The evaluation of the argument for or against repricing is open-ended There are valid reasons on both sides of the discussion Repricing can be viewed as a negative If an employee knows the option will be repriced if the stock declines, it provides less incentive However, if the stock price does decline dramatically, and underwater employee stock option provides little incentive since it may be unlikely that the stock price will reach the strike price before expiration Repricing increases the value of the employee stock option Consider an extreme: A company announces the employee stock options will be worth a minimum of $10 at expiration Since all values less than $10 are no longer possible, the value of the option increases Employee stock options increase in value if the stock price increases; however, the stock price can increase because of a general market increase Consider a company of average risk in a bull market that has a large return for several years The company’s stock should closely mirror the market return, even though most of the stock price increase is due to the general market increase Similarly, if the market falls, the company’s stock will likely fall as well, even if the company is doing well A better method of valuing employee stock options might be to reward employees for company performance in excess of the market performance, adjusted for the company’s level of risk To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 26 THE BIRDIE GOLF-HYBRID GOLF MERGER As with any other merger analysis, we need to examine the present value of the incremental cash flows The cash flow today from the acquisition is the acquisition costs plus the dividends paid today, or: Acquisition of Hybrid Dividends from Hybrid Total –$550,000,000 $150,000,000 –$400,000,000 Using the information provided, we can determine the cash flows to Birdie Golf from acquiring Hybrid Golf All earnings not retained are paid as dividends, so the cash flows for the next five years will be: Dividends from Hybrid Terminal value of equity Total Year Year Year Year $38,400,000 $12,800,000 $29,400,000 $41,400,000 $38,400,000 $12,800,000 $29,400,000 $41,400,000 Year $59,000,000 600,000,000 $659,000,000 To discount the cash flows from the merger, we must discount each cash flow at the appropriate discount rate The terminal value of the company is subject to normal business risk and should be discounted at the cost of capital, while the dividends are equity cash flows, and as such, should be discounted at the cost of equity The present value of each year’s cash flows, along with the appropriate discount rate for each cash flow is: Dividends PV of value Total Discount rate Year 16.9% $32,848,589 12.4% Year Year Year $9,366,578 $18,403,643 $22,168,806 $32,848,589 $9,366,578 $18,403,643 $22,168,806 Year $27,025,856 334,441,139 $361,466,995 And the NPV of the acquisition is: NPV = –$400,000,000 + 32,848,589 + 9,366,578 + 18,403,643 + 22,168,806 + 361,466,995 NPV = $44,254,610.07 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com C-70 CASE SOLUTIONS Since the acquisition is a positive NPV project, the most Birdie would offer is to increase the current cash offer by the current NPV, or: Highest offer = $550,000,000 + 44,254,610.07 Highest offer = $594,254,610.07 The highest share price is the total high offer price, divided by the shares outstanding, or: Highest share price = $594,254,610.07 / 8,000,000 shares Highest share price = $74.28 To determine the current exchange ratio which would make a cash offer and a share offer equivalent, we need to determine the new share price under the original cash offer The new share price of Birdie after the merger will be: PNew = ($94 × 18,000,000 + $44,254,610.07) / 18,000,000 PNew = $96.46 So, the exchange ratio which would make the cash offer and share offer equivalent is: Exchange ratio = $68.75 / $96.46 Exchange ratio = 7127 The highest exchange ratio Birdie would accept is an exchange ratio that results in a zero NPV acquisition This implies the share price of Birdie remains unchanged after the merger, so the exchange ratio is: Exchange ratio = $68.75 / $94 Exchange ratio = 7314 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 27 THE DECISION TO LEASE OR BUY AT WARF COMPUTERS The decision to buy or lease is made by looking at the incremental cash flows The incremental cash flows from leasing the machine are the security deposit, the lease payments, the tax savings on the lease, the lost depreciation tax shield, the saved purchase price of the machine, and the lost salvage value The salvage value of the equipment in four years will be: Aftertax salvage value = $600,000 – $600,000(.35) Aftertax salvage value = $390,000 This is an opportunity cost to Warf Computers since if the company leases the equipment it will not be able to sell the equipment in four years The lease payments are due at the beginning of each year, so the incremental cash flows are: Saved purchase Lost salvage value Lost dep tax shield Security deposit Lease payment Tax on lease payment Cash flow from leasing Year $5,000,000 –300,000 –1,300,000 455,000 $3,855,000 Year Year Year Year –$390,000 –129,675 300,000 –$583,275 –$777,875 –$259,175 –1,300,000 455,000 –$1,428,275 –1,300,000 455,000 –$1,622,875 –1,300,000 455,000 –$1,104,175 The aftertax cost of debt is: Aftertax cost of debt = 11(1 – 35) Aftertax cost of debt = 0715 or 7.15% And the NAL of the lease is: NAL = $3,855,000 – $1,428,275/1.0715 – $1,622,875/1.07152 – $1,104,175/1.07153 – $219,675/1.07154 NAL = $44,308.0 The company should lease the equipment –$219,675 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com C-72 CASE SOLUTIONS The book value of the equipment in year will be: Book value = $5,000,000 – $5,000,000(.3333 + 4445) Book value = $1,111,000 So, the aftertax salvage value in year will be: Aftertax salvage value = $2,000,000 + ($1,111,000 – 2,000,000)(.35) Aftertax salvage value = $1,688,850 So, the NAL of the lease under the new terms would be: Saved purchase Lost salvage value Lost dep tax shield Lease payment Tax on lease payment Cash flow from leasing Year $5,000,000 –2,300,000 805,000 $3,505,000 Year –$583,275 –2,300,000 805,000 –$2,078,275 Year –$1,688,850 –777,875 –$2,466,725 So, the NAL of the lease under these terms is: NAL = $3,805,000 – $2,078,275/1.0715 – $2,466,725/1.07152 NAL = –$583,099.11 The NAL of the lease is negative under these terms, so it appears the terms are less favorable for the lessee However, the lease will likely be classified as an operating lease The lease is now for two years, which is less than 75 percent of the equipment’s life according Using the company’s cost of debt, the present value of the lease payments is: PV of lease payments = $2,300,000 + $2,300,000/1.11 PV of lease payments = $4,372,072.07 This is less than 90 percent of the price of the equipment As long as the lease contract does transfer ownership to the lessee at the end of the contact, or allow for a purchase at a bargain price, the FAS 13 conditions for a capital lease are not met As such, the reason for suggesting the revised lease terms is unethical on Nick’s part Also, notice that the question also states that if the lease is renewed in two years, the lessor will allow for the increased lease payments made over the first two years This is also an indication that the revision is for less than ethical reasons To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 27 C-73 a The inclusion of a right to purchase the equipment will have no effect on the value of the lease If the company does not purchase the equipment, it can go on the market and purchase identical equipment at the same price b The right to purchase the equipment at a fixed price will increase the value of the lease If the company can purchase the equipment at the end of the lease at below market value, it will save money, or at a minimum, can purchase the equipment at the fixed price and resell it in the open market This is a real option, therefore has value to the lessee It is a call option on the equipment As such, it must have a value until it expires or is exercised It is also important to note that this would likely make the lease contract a capitalized lease c The right to purchase the equipment at a bargain price is also a real option for the lessee, and will increase the value of the lease It is a call option, and therefore will have value until it expires or is exercised This contract condition will definitely ensure the lease is classified as a capitalized lease The cancellation option is also a real option The cancellation option is a put option on the equipment It will increase the value of the lease since the lessee will only exercise the option when it is to the lessee’s advantage ... Equity = $89,139 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com C-2 CASE SOLUTIONS Balance sheet as of Dec 31, 2009 Cash Accounts receivable Inventory... and corporate airplanes Additionally, the Brazilian government is a part owner of the company Bombardier and Embraer are probably not good aspirant companies because of the diverse range of products... in this area To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com C-6 CASE SOLUTIONS Below is a list of possible reasons it may be good or bad that